Module 4: Risk and Rates of Return: FIN3403 Fall 2009

GT Concept Note ®
FIN3403 ‐ Fall 2009
Module 4: Risk and Rates of Return
Security Statistical Measures .............................................................................................. 2
Ex Ante Statistics for Securities.................................................................................................... 2
Example: Ex Ante Statistics for Securities............................................................................................ 2
Ex Post Statistics for Securities .................................................................................................... 3
Example: Ex Post Statistics for Securities ............................................................................................ 4
Zscores....................................................................................................................................... 5
Example: Finding the Z‐number, One‐Tailed Test............................................................................ 5
Example: Finding the Z‐number, Two‐Tailed Test........................................................................... 6
Portfolio Statistical Measures ............................................................................................. 6
Ex Ante Statistics for Portfolios.................................................................................................... 7
Example: Ex Ante, Expected Return of a Portfolio ........................................................................... 7
Example: Ex Ante, Variance and Standard Deviation of a Portfolio.......................................... 8
Ex Post Statistics for Portfolios .................................................................................................... 9
Example: Ex Post, Average Return of a Portfolio .............................................................................. 9
Example: Ex Post, Variance and Standard Deviation of a Portfolio ........................................11
Diversification and Market Risk ......................................................................................12
Example: Calculating Beta Directly .......................................................................................................14
Example: Calculating Beta Using a Calculator ..................................................................................14
More Practice with CAPM ...................................................................................................16
Example: CAPM #1 .......................................................................................................................................16
Example: CAPM #2 .......................................................................................................................................16

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Copyright © Gator Tutoring, LLC. All rights reserved.
GT Concept Note ®
FIN3403 ‐ Fall 2009
Security Statistical Measures
One of the most important elements of investing is risk. It represents the
uncertainty present in nearly every financial transaction. We usually assume that
investors earn a certain rate of return on their investments. However, there is
always the possibility that they will earn less return than they originally expected.
This is known as investment risk. Investment risk pertains to both individual stocks
and portfolios of stocks. The risk of an individual stock is known as its standard
deviation (denoted σ), whereas the risk of an entire portfolio is measured by beta
(β). Also, we can predict investment risk before we earn any return (ex ante), or we
can summarize the risk of an investment after we realize its return (ex post).
Ex Ante Statistics for Securities
Remember, ex ante statistics are those that deal with predictions; these predictions
are based on probability estimates for several different possible states of nature that
could occur in the future.
The expected return r̂ of a security is
N
r̂ = ∑ Pi ri
i =1
where Pi is the probability of the ith state of nature occurring, and ri is the return that
occurs in the ith state of nature. It’s basically our “best guess” about the average rate
we expect to earn.
The variance σ 2 of a security is
N
σ 2 = ∑ Pi ( ri − r̂ )
2
i =1
which, as we can see, uses the expected return r̂ . Variance describes the volatility of
a security’s expected return. The standard deviation σ also describes its volatility;
it’s just a more standardized measure. The standard deviation is simply the square
root of the variance; that is,
σ = σ2
Finally, the coefficient of variation (CV) gives us a picture of the return a security
earns, relative to its risk. The formula is
σ
CV =
r̂

Example: Ex Ante Statistics for Securities

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GT Concept Note ®
FIN3403 ‐ Fall 2009
State of Nature A B
High Period (40%) .15 .35
Low Period (60%) .05 ‐.05
Based on above table of ex ante data, find the expected return, variance, and
coefficient of variation for Security A.
Solution:
N
r̂A = ∑ Pi ri = .4(.15) + .6(.05) = .09
i =1
N
σ A2 = ∑ Pi ( ri − r̂ ) = .4 (.15 − .09 ) + .6 (.05 − .09 ) = .0024
2 2 2
i =1
σ .0024 .049
CVA = = = = .544
r̂ .09 .09

We can also find these statistics using our calculator – but we have to find a way to
input the probabilities of the different states of nature. The easiest way to do it is to
enter the number of times the state of nature occurs over some given number of
periods. The number of periods should make it easy to find out how many times the
particular state of nature occurs.
Let’s look at an example. From the previous table, there was a 40% chance security
A had a return of 0.15, and there was a 60% chance it had a return of 0.05. So, let’s
suppose that there were a total of 10 periods. Then, we’d expect our return to be
0.15 a total of four times, and 0.05 a total of six times.
Using our calculator, we would enter the following:
.15∑ + , four times
.05∑ + , six times
Then, we can find the mean (which is the expected rate of return) by pressing x, y ;
we obtain the 9% we found earlier. To find the standard deviation, press σ X , σ Y .
We find that the standard deviation is .049, as before.
Ex Post Statistics for Securities
Now we’re looking at statistics that summarize historical data.
The average return rAVG over the past t time periods is
⎛ N ⎞
rAVG = ⎜ ∑ rt ⎟ / ( N )
⎝ t =1 ⎠
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GT Concept Note ®
FIN3403 ‐ Fall 2009
where rt is the return in the tth time period. It’s what we earned each time period
(year, month, etc.) on average.
The variance V of the security over the past t time periods is
⎡N 2⎤
V = ⎢ ∑ ( rt − rAVG ) ⎥ / [ N − 1]
⎣ t =1 ⎦
and the standard deviation s is still the square root of the variance; that is,
s= V
Note that we denote the variance V and the standard deviation s when using ex post
data, to distinguish it from the variance and standard deviation of ex ante data,
which are denoted σ 2 and σ , respectively.

Example: Ex Post Statistics for Securities

Year A B
1 .15 .35
2 .11 ‐.05
3 .08 .13
4 .10 .12

Based on above table of ex post data, find the average return, variance for Security
A.
Solution:
⎛ N ⎞
rB = ⎜ ∑ rt ⎟ / ( N ) = (.23 + .08 + .13 + .12 ) / ( 4 ) = .14
⎝ t =1 ⎠
⎡N 2⎤
V = ⎢ ∑ ( rt − rAVG ) ⎥ / [ N − 1]
⎣ t =1 ⎦
= ⎡⎣(.23 − .14 ) + (.08 − .14 ) + (.13 − .14 ) + (.12 − 14.) ⎤⎦ / 3 = .004067
2 2 2 2
s = V = .004067 = .06377

To use our calculator for ex post statistics, we just enter in the value for each year.
Then, we can find the mean and standard deviation simply by pressing the
corresponding buttons.
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GT Concept Note ®
FIN3403 ‐ Fall 2009
Z‐scores
It’s important to understand some of the basics of the normal distribution (also
called z‐distribution), since it will often make sense to assume that a security’s rates
of return are distributed normally.

As we can see, the normal distribution is symmetric.
If our rates have a normal distribution, we know something about what percent of
the data lies in certain intervals. The following lists the most common intervals:
±1σ = 68.26%
±2σ = 95.46%
±3σ = 99.74%
Often, our observation won’t fall into one of these three convenient intervals. To find
exactly how many standard deviations away from the mean a certain rate of return
is, we use the following formula:
Z = [r − r̂] / σ
This gives us the znumber, which tells us how many standard deviations away
from the mean the observation is. We could then use a ztable to find out what
percentage of the data lies above the number.
Typically, z‐tables show the percentage of data that lies above a specific z‐number.
Since the normal distribution is symmetric, we can still use a table like this even if
we want to find the percentage of data that lies below a certain z‐number.

Example: Finding the Znumber, OneTailed Test
Suppose the mean rate of return is 8% and the standard deviation of 1.5%. We can
ask the question what is the probability that the observed rate of return will be
greater than 10%?
Solution:
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GT Concept Note ®
FIN3403 ‐ Fall 2009
Z = [r − r̂] / σ = [.10 − .08] / .015 = 1.333

So the rate of 10% is 1.3 standard deviations away from the mean (which is 8%).
Now, if we look up the z‐number of 1.33 in a z‐table, we’ll find that approximately
9.2% of the data lies in the upper tail – which means there’s a 9.2% chance of our
return being above 10%.

The z‐table also makes it easy to find the probability that a particular rate of return
will fall between two values.

Example: Finding the Znumber, TwoTailed Test
Assuming the same mean rate of return of 8% and standard deviation of 1.5%, find
the probability that our return will be in between 7% and 9.5%.
Solution:
First, calculate the two z‐numbers:
Z = [r − r̂] / σ = [.07 − .08] / .015 = −.67
Z = [.095 − .08] / .015 = 1.0
Now, find their corresponding probabilities from the z‐tables. Because of symmetry,
Z −.67 = Z.67 = .251
So there’s a 25.1% chance return is less than 7%. Since the area to the left of the
mean is 50%, the area between 7% and 8% is 50% ‐ 25.1% = 24.9%.
Z1 = 0.159
So there’s a 15.9% chance return is greater than 9.5%. Since the area to the right of
the mean is 50%, the area between 8% and 9.5% is 50% ‐ 15.9% = 34.1%.
Thus, the probability that the rate of return will be between 7% and 9.5% is 24.9% +
34.1% = 59%.

Portfolio Statistical Measures
A portfolio of securities is a collection of individual securities. So, when looking at
some of the statistical calculations, we can either treat the portfolio as a weighted
average of the securities that make it up, or as an individual security itself. Also, just
as with individual securities, we can look at ex ante portfolio data, or ex post
portfolio data.
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GT Concept Note ®
FIN3403 ‐ Fall 2009
Ex Ante Statistics for Portfolios
We must use the ex ante statistics of the individual securities that make up the
portfolio to find the statistical measures of the overall portfolio. The following
example illustrates both ways of doing this – looking at the weighted average of the
securities that make up the portfolio, or treating the portfolio as an individual
security itself.

Example: Ex Ante, Expected Return of a Portfolio
Suppose a portfolio is made up of 35% of security A and 65% of security B. The
following table shows the states of nature and returns for these stocks:

State of Nature A B
High Period (40%) .15 .35
Low Period (60%) .05 ‐.05

Calculate the expected return of the portfolio using a weighted average of the
expected returns for each security, as well as by treating the portfolio as an
individual security.
Solution:
First, let’s calculate the expected return for our portfolio using a weighted average
of the expected returns for each security.
We can easily calculate that the expected return for security A is r̂A = .09 and for
security B is r̂B = .11 . Since our portfolio has 35% invested in stock A, and 65%
invested in security B, our portfolio’s expected rate of return is
r̂P = .35(.09) + .65(.11) = .103 = 10.3%
Now, let’s treat the portfolio as a single security. To do this, we want to look at the
individual states of nature, and calculate what our portfolio would earn in each
state.
In the High Period, stock A earns 15% and stock B earns 35%. Since our portfolio
consists of 35% A and 65% B, in the High Period our portfolio will earn
Weighted Portfoliohigh = .35(.15) + .65(.35) = .28
and in the low period it will earn
Weighted Portfoliolow = .35(.05) + .65(−.05) = −.015
So the expected return is
r̂P = .4(.28) + .6(−.015) = .103 = 10.3%

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GT Concept Note ®
FIN3403 ‐ Fall 2009
Now, let’s look at how to calculate the portfolio variance. If we treat the portfolio as
an individual security, we only need to use the equation for variance we’ve already
seen.
If we want to calculate the portfolio variance based on the individual securities’
variances, we have to use a new formula:
σ P2 = WA2σ A2 + WB2σ B2 + 2WAWBCOVAB
where WA and WB are the weights of security A and B, respectively, and COVAB is the
covariance of security A with security B. The covariance is defined as follows:
N
COVAB = ∑ Pi ( rA,i − r̂A ) ( rB,i − r̂B )
i =1
From this definition, it follows immediately that the covariance of any security with
itself is just the variance of that stock; that is, COVAA = σ 2A .
The covariance of two stocks is also related to their correlation, by the following
formula:
COVAB = σ Aσ BCORAB
So, if we only knew the correlation, we could still solve for the variance of the
portfolio by substituting in this condition. The variance would then become
σ P2 = WA2σ A2 + WB2σ B2 + 2WAWBσ Aσ BCORAB

Example: Ex Ante, Variance and Standard Deviation of a Portfolio
Assume our portfolio is the same as in the last example. Find the variance and
standard deviation, first by treating the portfolio as an individual security, and then
by using the variances of the individual securities.
Solution:
Treating the portfolio as an individual security, we just need the formula from the
previous section:
N
σ P2 = ∑ Pi ( rP − r̂P )
2
i =1
From the last example, we know the expected return of the portfolio is r̂P = .103 .

The probability of a High Period was 40%, and our weighted portfolio return in the
high period was .28; also, the probability of a Low Period was 60%, and our
weighted portfolio return in the low period was ‐.015. Therefore,
σ P2 = .4 (.28 − .103) + .6 ( −.015 − .103) = .020886
2 2

σ P = .020886 = .1445
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GT Concept Note ®
FIN3403 ‐ Fall 2009
Now, let’s find the variance by looking at the individual securities’ variances. First,
we need to find the covariance between A and B. Based on the table in the previous
example, we find
N
COVAB = ∑ Pi ( rA,i − r̂A ) ( rB,i − r̂B )
i =1
= .4 (.15 − .09 ) (.35 − .11) + .6 (.05 − .09 ) ( −.05 − .11) = .0096
Now we can find the variance of the portfolio, since we have the covariance of A
with B. Assume σA2 = .0024 and σB2 = .0384.
σ P2 = WA2σ A2 + WB2σ B2 + 2WAWBCOVAB
= (.35)2 (.0024) + (.65)2 (.0384) + 2(.35)(.65)(.0096) = .020886
σ P = .020886 = .1445

Ex Post Statistics for Portfolios
We can also calculate the average return, variance, and standard deviation of a
portfolio using ex post data.
The average return of a portfolio is simply the weighted sum of the individual
securities’ average returns over a certain period of time.
We could also treat the portfolio as an individual security, and find its average rate
of return in each year; this would simply be the weighted average of what each
security earned in that year. We would then average the portfolio’s rate of return in
each year over a certain period of time.
Let’s look at an example using both methods.

Example: Ex Post, Average Return of a Portfolio
Suppose a portfolio consists 35% of security A and 65% of security B. The following
table shows the securities’ returns over the past 4 years.
Year A B
1 .15 .25
2 .11 .08
3 .08 .13
4 .10 .12
Calculate the portfolio’s average return, first by looking at the portfolio’s constituent
securities, and then by treating the portfolio as an individual security itself.
Solution:
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GT Concept Note ®
FIN3403 ‐ Fall 2009
We can easily find that security A averaged 11% over the last four years and
security B averaged 14%. Thus, our portfolio averaged
rP = .35(.11) + .65(.14) = .1295 = 12.95%
Now, let’s look at the portfolio as an individual security. We first need to find what
return the portfolio averaged each year.
Its return each year is just the weighted sum of the two securities’ returns each year.
The following table shows this:
Year A B P
(WArA + WBrB)
1 .15 .23 .202
2 .11 .08 .0905
3 .08 .13 .1125
4 .10 .12 .113

So, the average return over all four years is
rP = (.202 + .0905 + .1125 + .113) / 4 = 12.95%

Finally, we discuss how to calculate the variance and standard deviation of a
portfolio using ex post data. Treated as an individual security, the variance of the
portfolio is found using the same ex post formula from before:
N
VP = ∑ ( rP,t − rP ) / (N − 1)
2
t =1
where rP,t is the return of the portfolio in year t, and rP is the average return of the
portfolio over the last N time periods.
If we wanted to treat the portfolio as a collection of individual securities, we would
use the same formula that we did with ex ante data:
VP = WA2VA + WB2VB + 2WAWBCOVAB
Note that while the formula is the same, we will get a different number for variance,
since the variances of the individual securities are calculated differently with ex post
data than they are with ex ante data.
The definition of covariance in ex post is a little different:
N
COVAB = ∑ ( rA,t − rA ) ( rB,t − rB ) / [ N − 1]
t =1
The relationship between covariance and correlation still holds, though:
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GT Concept Note ®
FIN3403 ‐ Fall 2009
COVAB = SA SBCORAB
Again, note that the standard deviations used here will be different than they were
for the ex ante data.
Let’s practice calculating the variance and standard deviation using ex post data.

Example: Ex Post, Variance and Standard Deviation of a Portfolio
Using the same information from the previous example, find the variance and
standard deviation of the portfolio, treating the portfolio both as an individual
security itself, and as a collection of individual securities.
Solution:
First, we’ll treat the portfolio as an individual security:
N
VP = ∑ ( rP,t − rP ) / (N − 1)
2

t =1
(.202 − .1295)2 + (.0905 − .1295)2 + (.1125 − .1295)2 + (.113 − .1295)2

=
4 −1
= .00244617
The standard deviation is
SP = .00244617 = .04946
Now, looking at the portfolio’s individual securities, we first need to find the
covariance.
N
COVAB = ∑ ( rA,t − rA ) ( rB,t − rB ) / [ N − 1]
t =1
= (.15 − .11) (.23 − .14 ) + (.11 − .11) (.08 − .14 )

1
+ (.08 − .11) (.13 − .14 ) + (.10 − .11) (.12 − .14 )
(4 − 1)
= .0013667
We can now find the variance using the formula. Assume the variance of A is
.000867 and the variance of B is .004067.
VP = WA2VA + WB2VB + 2WAWBCOVAB
= (.35 2 )(.000867) + (.65 2 )(.004067) + 2(.35)(.65)(.0013667) = .00244617
The standard deviation is
SP = .00244617 = .04946

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GT Concept Note ®
FIN3403 ‐ Fall 2009
Diversification and Market Risk
The basic idea behind diversification is pretty simple. If you only invest in one
company, and that company takes a fall, your entire portfolio is at risk. If, however,
your portfolio only consists of 25% of that company, you have minimized your
exposure to the riskiness of that company.
This is diversification; you don’t want to keep “all of your eggs in one basket.” The
more independent companies you invest in, the more diversified your portfolio is,
and the less company‐specific risk you are exposed to. A natural question to ask is,
can we diversify away all of our risk? The answer is no. There is some risk that is
present in every security in the market – it is called market risk.
The way to measure the market risk (or non‐diversifiable risk) of a security is to
find its beta. It represents how volatile the security is relative to the overall market.
(Note: the beta of a portfolio is the weighted sum of the betas of the securities in the
portfolio).
The formula for beta is
COVAM
BetaA =
σ M2
where COVAM is the covariance of security A with the market, and σ M2 is the variance
of the market. This can also be written as
BetaA = CORAM (σ A / σ M )
Basically, beta measures how many times more risky a security is than the overall
market; so, a beta of 1.0 means the security is just as risky as the overall market.
Here are some general cases:
COVAM > σ 2M ⇒ BetaA > 1.0
COVAM < σ 2M ⇒ BetaA < 1.0
COVAM = σ 2M ⇒ BetaA = 1.0
Investors that properly diversify their portfolios are still exposed to this non‐
diversifiable risk. So, they expect to be compensated for it. The security’s
characteristic line tells us, for a given market rate of return, what risk premium an
investor would require for the particular riskiness of his company. It is based on the
beta of the security.
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GT Concept Note ®
FIN3403 ‐ Fall 2009

How do we calculate this risk premium? Recall the equation for the nominal rate of
interest of a security:
r = rRF + Risk Premium
Rearranging the above equation, we can find the risk premium of the market:
Risk PremiumM = rM − rRF
Now, we can multiply the risk premium of the market by the beta of the security to
find the risk premium of the security.
Risk PremiumA = ( rM − rRF ) ( BetaA )
The security’s total required rate of return, then, is the risk‐free rate, plus the risk
premium:
rA = rRF + ( rM − rRF ) ( BetaA )
This is called the Capital Asset Pricing Model (CAPM), and it’s used to predict an
investor’s required rate of return on a security. The graph of this equation is called
the security market line (SML).

Over time, the SML may change shape. Two factors affect this: expectations about
inflation, and the level of risk aversion. If investors expect inflation to increase, the
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GT Concept Note ®
FIN3403 ‐ Fall 2009
risk‐free rate will increase; so, the SML will shift up. If investors become more risk
averse, they will require more return for a given amount of risk; so, the SML will
rotate up (which is an increase in the slope).
The equation for calculating beta doesn’t change whether we’re finding ex ante or ex
post data; only the variance and covariance do. Let’s look at some examples.

Example: Calculating Beta Directly
Suppose in ex ante the covariance of a security A with the market is COVAM = .0115
and the variance of the market is σM2 = .0085, and in ex post COVAM = .031 and VM =
.009. Find the beta of security A using both the ex ante and the ex post data.
Solution:
First, ex ante:
BetaA = .0115 .0085 = 1.353
And ex post:
BetaA = .031 .009 = 3.44

Instead of using the covariance and variance, we can calculate the beta of a security
by running a regression on historical (ex post) data. The dependent variable will be
the security’s return, and the independent variable will be the market return. So, it
will be of the form
rA = c + β A (rM )
The slope, then, will be the beta of the stock.
Our calculator can actually do this for us – the next example shows how.

Example: Calculating Beta Using a Calculator
Suppose the following table shows us the return security A earned over the past
four years, as well as what the market earned:
Year A M
1 .15 .11
2 .11 .09
3 .08 .09
4 .10 .095
Find the beta of security A by running a regression on your calculator.
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GT Concept Note ®
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Solution:
To run the regression on our calculator, we have to enter in all the points. For each
pair of points, we enter in the independent variable (the market rate) first, then
press INPUT, then enter the dependent variable (the security’s return), then press
Σ+. Press the following on your calculator:

Now that the data is entered, we just need to calculate the slope. Press shift ŷ, m ;
this will give you the intercept. Press shift SWAP, and you’ll get the slope, which is
the beta:
β A = 2.79

Since beta is determined by the riskiness (essentially, the variance) of security A, we
can use our calculated beta to find what return the security should have earned
(using CAPM), and then compare it to what it actually earned. The difference
between the actual return and the expected (required) return is called Jensen’s
Alpha. The larger the Jensen’s Alpha of a security, the more attractive that security
is.

Example: Jensen’s Alpha
Using the information from the last example, and assuming the risk‐free rate was
3% over the past four years, find Jensen’s Alpha for security A.
Solution:
We can easily find that the average market return over the last four years was
9.625%.
Recall the equation for the rate of return for security A (CAPM):
rA = rRF + ( rM − rRF ) ( BetaA )
rA = .03 + (.09625 − .03) ( 2.79 ) = .2148 = 21.48%

So, this is the required rate of return (per year) for security A. We must now find
security A’s average rate of return (per year) over the last four years.
rA = (.15 + .11 + .08 + .10) / 4 = .11 = 11%
Jensen’s Alpha is the difference between the average rate and the required rate:
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GT Concept Note ®
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Alpha = rJ − rJ
Alpha = 11% − 21.48% = −10.48%
So, security A underperformed its expectation by 10.48%.

More Practice with CAPM
The basic CAPM formula that’s used to predict an investor’s required rate of return
for security A is
rA = rRF + (rM − rRF )(β A )
which can also be written
rA = rRF + RPM (β A )
since the market risk premium is equal to the required rate of return on the market,
minus the risk‐free rate. If we know all but one of the components of the CAPM
equation, we can solve for the other one. Let’s look at some examples.

Example: CAPM #1
Suppose security A has a required return of 11% and a beta of 1.11. If security B has
a beta of .97, and the risk‐free rate is 3.5%, what is security B’s required rate of
return?
Solution:
First, use A’s information to find the market risk premium.
.11 = .035 + RPM (1.11)
RPM = .0676
Now we can use CAPM to find B’s required rate:
rB = rRF + RPM (β B )
rB = .035 + .0676(.97) = .10

We can also use CAPM on a portfolio of securities. The beta of a portfolio is simply
the weighted sum of the betas of the securities that make it up.

Example: CAPM #2
Suppose a portfolio is made up of 35% of Stock A and 65% of Stock B, and the
portfolio’s required rate of return is 12%. If the risk‐free rate is 4%, the required
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GT Concept Note ®
FIN3403 ‐ Fall 2009
rate of return on the market is 11%, and Stock A has a beta of 1.15, what is the beta
of Stock B?
Solution:
First, we can find the beta of the overall portfolio:
rP = rRF + RPM (β P )
.12 = .04 + (.11 − .04 ) β P
βP =
(.12 − .04 ) = 1.143
(.11 − .04 )
Now, we know the beta of the portfolio is the weighted sum of the betas of the
individual securities. So
β P = .35 ( β A ) + .65 ( β B )
1.143 = .35 (1.15 ) + .65 ( β B )
βB =
(1.143 − (.35 *1.15)) = 1.139
.65

We could also find the weights of the stocks making up a portfolio if we had their
dollar amounts.
For example, suppose we had a portfolio worth $100,000 and it was all invested in
Stock A. Then, we know the portfolio has the same beta as Stock A. If we add an
additional $50,000 to the portfolio, and invest it in Stock B, the new portfolio beta
would be
100, 000 50, 000
βP = (βA ) + (βB )
150, 000 150, 000
If we knew the risk‐free rate and the market risk premium, we could then find the
new required rate of return on the portfolio.
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GT Concept Note ®

.05∑ + , six times

Z = [r − r̂] / σ = [.10 − .08] / .015 = 1.333

From the last example, we know the expected return of the portfolio is r̂P = .103 .

(.202 − .1295)2 + (.0905 − .1295)2 + (.1125 − .1295)2 + (.113 − .1295)2

= (.15 − .11) (.23 − .14 ) + (.11 − .11) (.08 − .14 )

rA = .03 + (.09625 − .03) ( 2.79 ) = .2148 = 21.48%

1.143 = .35 (1.15 ) + .65 ( β B )

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